Turmoil exposes risks in $9B pension fund

Maybe I’m an incurable optimist, but I see a silver lining in the recently stormy financial markets — the jolt might just wake up elected officials to the actual risks they are taking with public money in San Diego County’s pension fund.

In 2010, the board responsible for the county’s $9.4 billion fund gave its new investment adviser a green light to pursue a relatively new investment strategy known in the hedge fund industry as “risk parity.”

Advocates say the strategy is the closest thing yet to an investing free lunch: Using leverage and sophisticated mathematics, you can make higher returns with lower risk than traditional portfolios.

If risk parity sounds too good to be true, that’s because it is, according to a host of prominent critics.

“This is all bull,” said Zvi Bodie, a Boston University economist and finance professor who is a frequent critic of the financial services industry. “It is scary, and it’s very scary that anyone would believe it.”

“Nonsense,” is how Warren Buffett, the world’s most successful investor, describes Modern Portfolio Theory, the intellectual basis for risk-parity strategy. “Asinine,” is the term preferred by his business partner, Charlie Munger.

MPT holds that an investor can infer the risk of a security by calculating how far its price swings up and down in the markets over time. Risk parity involves loading up on supposedly low-risk investments to boost returns.

Buffett points out that price swings tell you nothing about a company’s true risk — that it might go bankrupt and default on its bonds. Indeed, if you find a well-managed company and wait to buy its stock until after the price crashes, you’ve actually reduced the risk of losing money on that investment. Volatility is not the same as risk.

Indeed, market volatility has hammered risk-parity hedge funds recently, just as San Diego County has increased its bets on the strategy. The Wall Street Journal reported last week that such funds have lost up to 8 percent so far this year, and lag roughly 13 percent behind funds that replicate the traditional pension portfolio of 60 percent stocks and 40 percent bonds.

What scares me most is the amount of leverage they use. Under Lee Partridge, the outside adviser who controls the fund’s investments, San Diego County uses derivatives to generate $1.35 in market exposure for each $1 it really has.

There are other reasons to worry. When the pension fund hired Partridge in late 2009, the county was his only client. A bond trader by experience, this was his first time directing the investments of an entire pension fund.

And he was recommended by Hewitt Ennisknupp, the county’s consulting firm that is supposed to provide independent advice on whether a manager is steering the fund off a cliff. Not surprisingly, the firm endorsed Partridge’s venture into leveraged risk parity.

The pension board recently corrected that shortcoming by replacing Ennisknupp, but the new firm hasn’t given its views on the county’s investment policy.

According to the fund’s 2012 annual report, Partridge has used the fund’s 35 percent leverage level to bet heavily on bonds, mostly U.S. Treasuries.

Treasuries have delivered above-average returns for 30 years, but replicating that feat over the next decade is nearly a mathematical impossibility.

Sudden moves in bond values have rocked markets since May 22, when Federal Reserve chairman Ben Bernanke outlined the central bank’s strategy to eventually halt its massive bond-market intervention and raise interest rates. A similar Fed surprise in 1994 led to brutal losses for bond traders caught with “long” positions.

To be clear, I can’t tell you that the county pension fund has lost a pile of money this month. Partridge has refused to talk to me for months. Fund officials declined to comment last week, saying they will release their next quarterly report Aug. 15.

In a March interview, Partridge told me that his use of highly liquid futures contracts would allow him to quickly unwind the county’s trading positions in a crisis, based on his 20 years of bond-trading experience. Maybe he did.

My latest information comes from the fund’s report for the quarter that ended March 31, before the latest turmoil in stock and bond markets. The fund posted a 3.5 percent overall return, beating its preferred benchmark.

Then, in a case of horrible timing, Partridge in April gave an “educational” presentation at the pension board’s retreat that extolled the virtues of raising the county’s leverage to a whopping 137.5 percent.

His idea would make the county’s $9 billion earn like a $21 billion diversified portfolio – supposedly with less risk – by reducing the proportion of investments in blue-chip U.S. stocks and instead betting billions on Treasuries, foreign bonds, commodities, real estate, hedge funds and private equity managers.

I nearly fell out of my chair. The proposal rattled even Mike Sebastian, an Ennisknupp consultant who wrote a paper advocating alternative investments titled “Go Big or Go Home: The Case for an Evolution of Risk Taking.”

Under questioning from County Supervisor Dianne Jacob, Sebastian said the idea involved too much risk-taking to chase too little extra returns. It’s like “using a sledgehammer to kill a fly,” he said.

This idea of taking on more leverage has Jacob, who endorsed Partridge and his strategy in 2010, “deeply concerned,” she said last week. She’s asked for a review of the county’s investment policy. Other officials stress that the board has no formal plan to consider expanding its leverage.

I’ll point out here that two months, or even the three-plus years that Partridge has run the fund, is not enough time to judge the performance of an investment manager.

His record has been good: officials say the fund averaged an 11.4 percent annual return in the first 39 months of Partridge’s contract. The S&P 500 averaged 10.3 percent during the same period, including reinvestment of dividends.

Of course, managers may simply be lucky in the short run. Sustained success requires two ingredients: A sound strategy, and a skilled practitioner. The latter is why everyone can’t just read an investment book and then perform like Buffett, who’s earned his investors 20 percent a year over five decades or so.

The pension board has no idea whether Partridge is skilled, and it won’t for years. But it should know by now that his strategy carries a great deal of risk.